The Basics of Project Finance

What is Project Financing (or Project Finance)?

The term "project finance" is generally used to refer to a nonrecourse
or limited recourse financing structure in which debt, equity, and
credit enhancement are combined for the construction and
operation, or the refinancing, of a particular facility in a capital-
intensive industry, in which lenders base credit appraisals on the
projected revenues from the operation of the facility, rather than the
general assets or the credit of the sponsor of the facility, and rely on
the assets of the facility, including any revenue-producing contracts
and other cash flow generated by the facility, as collateral for the
debt.
How is Project Finance Used?
Whether termed "international project finance," "global project
finance" or "transnational project finance," the financing technique of
bringing together development, construction, operation, financing
and investment capabilities from throughout the world to develop a
project in a particular country is very successful. The technique is
being used throughout the world, in emerging and industrialized
societies.
Examples of Facilities Developed with Project Finance
[1] Energy Generation. Project finance is used repeatedly as
a financing technique for construction of new energy infrastructure.
It is used in industrialized countries, such as the United States, in
emerging countries, such as in Eastern Europe, the Pacific Rim or in
countries with tremendous new infrastructure demands, such as in
Latin America.

In emerging countries, project finance presents an alternative to the

traditional, non-market-based development of electricity resources.
Traditionally, in these countries, electrical resources were owned by
vertically integrated public monopolies that generated, transmitted
and distributed electrical power, financed by the utility or official
borrowing, and subsidized by the local government or cross-
subsidized by various customer groups (industrial versus residential,
for example). Project finance permits the traditional structure to
move from these monopolies to private generation of electricity. The
traditional monopoly is being broken down through various models,
including privatization of existing assets, encouragement of private
development of new electrical production and establishing the
government-owned utility as a purchaser of power for transmission
and distribution over existing facilities, or a combination of these.
Project finance is possible where a firm, credit worthy purchaser of
power enters into a long-term contract to purchase the electricity
generated by the facility.

Private power projects financed on a project finance basis are

developed by a special-purpose company formed for the specific
purpose of developing, owing and operating the facility. It has no
other assets or previous operations. Lenders rely on the cash flow of
the project for debt repayment, and collateralize the loan with all of
the project's assets. A power sales agreement, a type of off-take
contract, is the linchpin of the project. This contract creates a long-
term obligation by the power purchaser to purchase the energy
produced at the project for a set price. To the extent the project is
unable to produce sufficient revenues to service the debt, the
project's lenders have recourse to the project assets. No recourse is
available to the project sponsors, however.

[2] Pipelines . Storage Facilities and Refineries. Development

of new pipelines and refineries are also successful uses of project
finance. Large natural gas pipelines and oil refineries have been
financed with this model. Before the use of project finance as a
financing technique, these facilities were financed either by the
internal cash generation of oil companies, or by governments.

[3] Mining. Project finance is also used as a financing

technique for development of copper, iron ore, bauxite mining
operations in countries as diverse as Chile, Peru and Australia.

[4] Toll Roads. Development of new roads is sometimes

financed with the project finance model. The capital-intensive nature
of these projects, in a time of intense competition for limited
governmental resources, make project finance based on toll
revenues particularly attractive.

[5] Waste Disposal. Similarly, project finance is an attractive

financing vehicle for household, industrial and hazardous waste
disposal facilities. The revenue generated by so-called "tipping fees"
(the term has its genesis in the physical act of a garbage truck
"tipping" its contents at a landfill) can be the revenue flow necessary
to support a project financing.

[6] Telecommunications. The information revolution is

creating enormous demand for telecommunications infrastructure in
developed and developing countries. Project finance provides a
financing vehicle that can be used for this infrastructure
development.

[7] Other Projects. The use of project financing is limited only

by the necessity of a predictable revenue stream and the creativity
of financiers and counsel. Other uses include pulp and paper
projects, chemical facilities, manufacturing, retirement care facilities,
airports and oceangoing vessels.

[8] Uses by Industrial Companies for Growth and

Restructuring. In addition, project financing can be used by
industrial companies for expansions, new project development,
financing joint venture assets, and financial restructuring. Also,
industrial companies apply project financing structures in connection
with unbundling capital intensive, non-core assets, such as energy
production facilities.
Use in Emerging Economies
Until the early 1970s, much of the financing of infrastructure
development in emerging countries came from government sources,
such as the host country government, multilateral institutions and
export financing agencies. More recently, however, constraints on
public funding have emerged. These constraints include reductions
in developing country financial aid funding. Also, host country
governments lack the financial creditworthiness to support
financially, through direct funding or credit support, the volume of
infrastructure projects required to develop their economies.

At the same time, a global sea change took place in the view of
many governments, multilateral institutions and public entities in
infrastructure development. In this new world order, more reliance is
placed on the private sector, in both developing and industrialized
countries, as governments accept that the private sector is often
better able to develop, construct and operate large-scale
infrastructure projects. A deterioration of financial conditions in
developing countries, a move toward privatization of infrastructure in
both developing and industrialized countries, increased demand for
financial aid from former Soviet-block countries and countries in
Central Asia, are combining to make private sector involvement very
important.

These changes, coupled with the lack of capital in developing

countries, result in a need for foreign investment to satisfy growing
infrastructure needs. This need is based on the tenet that
infrastructure projects are the cornerstone for economic
development. The private sector is emerging as an important
financing source for infrastructure development in these countries.

The stability and predictability favored in project financings

make structuring project finance transactions difficult and expensive
in the developing countries of the world, because of the complexity
of risk allocation among multiple parties (including lenders, political
risk insurers, multilaterals and bilaterals) and the higher returns
required to compensate parties for the risks involved. Investors and
project lenders, preferring predictability to uncertainty, must be
assured that the economic assumptions underlying a project,
including revenues, taxes, repatriation and other economic factors,
will not be disrupted by host country action. These countries, of
course, are by nature developing economic, labor, legislative,
regulatory and political frameworks for growth and prosperity, not
yet as settled (or at least as predictable) as the developed world.
While project finance risk allocation is important in all countries, it is
of particular importance in the developing world.

The business environment in a developing country is different in

at least four major respects from the developed world: legislative
and regulatory systems; political security; economic security and
centralized infrastructure systems.
 Legislative and regulatory systems are usually not as defined as
in the developed countries. Environmental laws and policies, for
example, have not yet been aggressively pursued in developing
countries. Also, these countries might not have in place detailed
systems for dealing with foreign lenders and foreign equity investors,
on such matters as ownership of infrastructure projects, taxation and
repatriation of profits.

Political security is another area of uncertainty for project

financings in developing countries. Political security typically results
in higher costs necessitated by the need for complex insurance
programs and higher equity and debt rates. Political risks, include
expropriation, civil unrest, war, expatriation of profits, inconvertibility
of currency and breach of contractual or other undertakings by the
host government.

Economic insecurity arises in a project financing from the

inability of the potential project user to support the project through
use or purchases, either in demand or in ability to pay. Infrastructure
projects might provide a needed service, but at a price that cannot
be afforded by the great majority of the population. Even if delivered,
collections practices may be poor.

Either because of political theory, a lack of private capital,

multilateral investments or nationalization programs, most
infrastructure is owned by the government in developing countries.
This public-sector ownership structure eliminates the effects of
competition and increases the likelihood of inefficiencies.

Consequently, developers of proposed infrastructure projects

must consider the effect of this public-sector structure on the
proposed private-sector project. Possible effects include whether the
private project will compete with the existing public-sector projects,
which are arguably more likely to reduce charges for output or use in
exchange for short-term political gains; whether there will be a
privatization of all government- owned infrastructure projects, and
the effect of that on the private-sector project; and ongoing rigidity
inherent in working with government bureaucrats responsible for
existing facilities.

Each of these four differences (legislative and regulatory

systems; political security; economic security; and centralized
infrastructure systems) results in a risk portfolio for the private-
sector project that potentially includes higher construction and
operating costs (such as inflation, unavailability of efficient foreign
exchange markets, no long- term currency swap market, delays, cost
overruns); great demand for project output or use; inability of
population to afford the project output or to use the project (prices
are low; collections are poor; transferability of profits is difficult;
there is a mismatch of host government revenues from local
customers with foreign debt; questionable safety of investment from
nationalization). Therefore, nonrecourse and limited recourse project
financings are considered extremely difficult to accomplish in the
developing world, and require intensive attention to risk mitigation.
 The easiest solution is to use government guarantees covering
payment, convertibility, and other risks. However, this approach is
neither a long-term solution nor in favor with host governments and
multilateral institutions. There is a financial limit to the amount of
contingent guarantees that a government can and should enter into.
Other alternatives can be explored.

The project-based financing is emerging as a hybrid financing

technique that mixes project finance and corporate finance
techniques. While project sponsors desire to achieve many of the
goals of nonrecourse project financings, the risk involved in
developing countries often requires that some sort of recourse to the
project sponsors be in place. Consequently, rather than full recourse
corporate finance, project-based financing in developing countries
probably will require project sponsors to accept some form of limited-
recourse obligations. The extent of recourse will vary project-by-
project and country- by country.
Adapted from Institute of International Project Finance
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